Today’s post is a double header with the first part focusing on thoughts as to the current markets and the second on longer-term issues that should be considered for investment policy considerations.
I suspect a “Melt-Up”
In last week’s post I discussed three possible directions for the current market, “melt-up, muddle along, and decline.” At this juncture, for at least awhile, the apparent path of least resistance is to go up in price.
There is a belief that surviving a problem that doesn’t kill you makes you stronger. Most global stock markets did not fall on the two threats to geo-political peace last week; the downing of the Malaysian airliner over Eastern Ukraine and the beginnings of the Gaza strip ground attack. If the markets did not fall, then some believe the path of least resistance is for stock prices to rise. (Remember it took one month from the assassination of the Austrian Archduke and when World War I was declared on the European continent.)
Often when low to intermediate credits rise in price (decline in yields) relative to high quality paper, it is favorable to stock prices. Each week Barron’s publishes a confidence index based on this relationship. Normally it is quite stable. For the week that just ended the current reading was 69.9% vs. over 74% one year earlier. English translation is “risk-on.”
Because so many analysts and portfolio managers are relatively new to the business they tend to look at past history in terms of calendar movement of the Standard & Poor’s 500 index. They do not recognize that in an average year since 1980, according to JP Morgan Chase there is a 14.4% decline from peak to bottom. I am particularly sensitive to 1987 when for the year the S&P 500 index was up slightly but there was a -34% peak to trough decline thru the year, and much worse in the average stock. In our analysis of mutual funds for our clients we pay particular attention to the declines of- 49% and -19% in 2008 and 2011 respectively. But who cares, the market always come back.
The consulting community and institutional “gate keepers” pay attention to ranked performance particularly of short periods. We have maintained for some time there is little in the way of persistency of good performance from quarter to quarter and even for one year and particularly for three years. S&P recently did a study of top first quarter performers for the first quarter of 2012. They compared these winners to the top 25% winners for the similar quarter two years later. They found that only 3.78% of the funds repeated in the top quartile. What were even worse were the large capitalization funds where only 1.9% repeated. Remember large cap stocks have more analysts following them than smaller companies. What this suggests is that the market may well be shifting to favor short-term momentum winners which would be leaders in a sharply rising market.
Ignoring what you don’t like
If you can ignore facts and views that are cautious, one can become more bullish quite quickly. Some of the subjects that investors seem to be ignoring are:
1. Private Equity Funds are selling their holdings at high valuations.
2. Lust for yield is forcing investors into less conventional-higher risk paper.
3. People seem to forget that most Merger & Acquisition deals work out poorly for continuing investors. That it took so long for Steve Forbes to find an acquirer for the majority of his company shows that the private equity buyers are more cautious now than the public investors.
4. Interest rates are rising each week, for example: 15 and 30 year mortgage rates, new car loan rates and the banks’ cost of deposits (MMDA). At the same time numerous banks are reporting, as forecast, lower quarterly earnings and are looking to new markets to replace their crunched earnings power, e.g. PNC. This is occurring in a period when people are saving less and the spreads between high and low credit quality is narrowing.
5. Many US investors are turning to Europe to find good investments. This surge in demand has led to a 102% increase in Western Europe High Yield issuance in the first half of the year. (Anytime there is an increase in low credit quality issuance I wonder when we will see a meaningful uptick in defaults.)
This is the famous title of an open letter to the President of France by Emile Zola about the “Dreyfus Affair” which eventually led to Captain Dreyfus being exonerated and a public recognition of societal biases in France. In a far less dramatic context I accuse my fellow members of the global financial community of complacency. While we all see any number of troubling events, most do not change or plan to change our investment positions. In effect many have elected to play “the greater fool theory” card in an undisciplined way. A few of the things that should cause at least some of us to begin to shift away from risk of loss of capital are as follows in no particular order:
The sale of the Russell indexes to the London Stock Exchange opens more questions as to the future value of index production.
Internally both the US and Canadian central banks are looking for methods of improving their research in private recognition that they have not been very good.
We are seeing considerable “flight capital” movements. In the US the net sales of international funds is increasing as domestic oriented funds are in slow growth or net redemptions. In Europe we are seeing that the bulk of the long-term fund sales are not in funds from cross-border managers and are often going into investments outside of their domestic market.
Some very visible investors have made the following statements:
Carl Icahn:“This is the time to be cautious.”
David Kotok: of the esteemed Cumberland Advisors indicates that tapering is now going to be tightening.
Kathleen Gaffney: Well-known bond fund manager now of Eaton Vance* noted that traditional bonds have interest rate, credit and liquidity risks which is shoving us into unconventional paper.
*Stock owned by me personally and/or the private financial services fund I manage
An example of a real concern of mine is the discussions of an informal group of retirees, semi-retired and active portfolio managers, analysts both fundamental and technical, and an experienced institutional salesman. In periodic meetings, from my viewpoint, too much of this group’s discussion is on the issues of the day (often political) and not enough about individual securities and portfolios.
This group may well be a microcosm of the investment community trying to get the last high price for what they own while wringing their hands as to problems facing the investment world. Within my own responsibilities I have only recently started to sell long held positions, but still are very much an investor in equity funds and some individual stocks, mostly in the global financial services arena.
What we should be doing if the melt up gathers momentum is to place sell orders at various different levels so that we maintain our survival capital for the next major bull market, which I expect beyond the next five years.
To my readers at Citywire Global
Thanks to my City, UK and European readers for once again making my blog one of your top choices. Last week’s post was listed as Number One of the five most read stories on Citywire Global. I appreciate your readership.
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A. Michael Lipper, C.F.A.,
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Contact author for limited redistribution permission.